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The Beauty of Compounding & Importance of Rate of Interest

 This is said so often, ever so often. We've learnt it in high school - remember all those simple interest and compound interest rate formulas? It's amazing - the simplicity of the math. What does compounding mean? Why is it used so often in conjunction with wealth creation?

Well, let's dive right into it. The amount that you are going to invest in your first year - say on 1st of January, that's the principal amount. Let's say you just received your year end bonus of 1 lakh; and you decide to place this entire sum in a Fixed Deposit (FD) in your regular bank; which gives you 6.5% interest per annum.

Let's see what happens to your money. Your money (1 lakh @ 6.5% per year) grows to 1 lakh and 6.5k in exactly one year. But the magic starts in the second year. Your new starting point is now 1,06,500 which @ 6.5% - becomes 1,13,423 by January 1, 2021 - i.e. after 2 years. In the table below, you can see how the money grows year on year (Y-O-Y).

But the beauty is understanding the importance of the rate of interest.


Looking at the figure on the right; you can see the different amounts after 7 years - @ 6.5%, 7% & 7.5%. There is a significant increase of 10k to your savings by getting 7.5% vs 6.5%. Imagine having put 10 lakhs as your starting principal - then the difference would be 10 times, i.e. - an increment of 1 lakh to your savings just by choosing a bank that gives you a 1% higher rate of interest. The amount you put in your FD is the same - only variable being the rate of interest.

I have not considered the tax component that may get cut from your interest component - but we shall delve into this at a later point.

How do I know how much rate of interest my bank offers?
Every bank puts up these figures on its website. I have copied the HDFC FD rate below as an example. These get updated regularly based on several macro factors, RBI guidelines etc.



Summary:
While compounding is a critical concept in wealth creation - it's important to also understand that - the rate of interest your bank offers you for your FD is important as well. Compounding starts to really show its magic after the first couple of years as your money grows - and the longer time frame you choose for your FD, the more savings you will amass.

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